Cracking 'The Fibonacci Code'

I just finished reading The DaVinci Code on vacation. I wanted to get through it before the butchered two-hour Hollywood version comes out in May. My wife warned me that Fibonacci makes a cameo appearance in the book, so I wasn't surprised to see the progression of numbers so familiar to modern traders:

1, 2, 3, 5, 8, 13, 21 and so on.

Leonardo of Pisa (c. 1170-1250), also known as Fibonacci, studied mathematics among the Arabs and introduced algebra and arithmetic to Europe, as well as a logical sequence that appears throughout nature. Beginning with 1+1, the sum of the last two numbers that precede it creates another number in the Fibonacci set: 1+1=2, 1+2=3, 2+3=5, 3+5=8, 5+8=13, 8+13=21, 13+21=34, 21+34=55.

The commonly observed market retracement levels of 38%, 50% and 62% are derived from ratios of this arcane number series. In most cases, they're used to predict how far a stock or futures contract will pull back after a rally or selloff before it bounces firmly in the other direction.

Of course, not everyone uses or believes in this esoteric methodology. Many traders are quite skeptical, dismissing this type of analysis as nothing more than market voodoo. But that hasn't stopped me from using it religiously since the mid-1990s.

I've applied all sorts of voodoo techniques to trading in the last 15 years. These voyages to the dark side include Elliott Wave Theory, Gartley patterns and even phases of the moon. I'll try anything if it can make me a few bucks.

In reality, voodoo trading can add a lot to your bottom line. Gann, Elliott and other cultists spent years studying the market's mystical side and how obscure ideas can tap hidden profits. Magic numbers, astrological dates and prayer wheels have all been enlisted in the quest to get an edge in the market.

Markets swing off common retracement levels as they move from support to resistance and back. But these dynamics have become harder to trade in recent years. The popularity of Fibonacci analysis is the likely reason.

Many smart players trade against key retracement levels because they know weaker hands will jump in at these prices. For example, they'll sell at Fib support just because retail traders expect a bounce at that level. But Fibonacci applications still have tremendous value for swing traders.

The trick is to use an original approach. Never trade a retracement level in a vacuum. Instead, look for other forms of support or resistance to show up at the same price levels. For example, when you see a 50-day moving average, an intermediate high and a trend line converge at a 62% retracement, the odds for an important reversal greatly increase.

Sears Holding (SHLD - commentary - Cramer's Take) shows how this cross-verification process can increase confidence in buying pullbacks. The stock exploded out of a five-month base last week and is pulling back. Notice how multiple types of support are lining up near $123. This price level offers a low-risk entry point for a rally above last week's high of $139.

You can also trade the Fibonacci whipsaw. Stand aside as price pulls back to a deep retracement level, like 62%. Let other traders take the bait and get shaken out after price breaks through the key number. Then watch for a reversal near 78% and a bounce that carries it back across the 62% level. Use this crossover as your long-side entry signal.

This trade works well because the markets usually punish only one side of the price action at a time. So the flushing out of weakhanded long positions when the market breaks common support often sets up an excellent "failure" trade once the contested level is remounted.

Delving deeper into retracement strategies can also help you avoid the crowd. H.M. Gartley described little-known Fibonacci relationships in his 1935 book Profits In The Stock Market. The Gartley Pattern, which relies on a 78% retracement, is another way to capitalize on those caught in a 62% whipsaw. This classic setup works just as well now as it did during the Great Depression.

You can also trade Fibonacci extensions instead of retracements. Followers of Gartley's work have devised an extension trade called the Butterfly Pattern. This is a complex formation, which carries price about 27% past a 100% retracement before price reverses. Got that?

The combination of all these waves and ratios can be confusing to newer students of the financial markets. But one of the joys in applying complex Fibonacci mathematics is its ability to confuse most public traders. After all, the markets rarely reward the common plays of the majority.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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